Understanding

Natural Gas Markets

Table of Contents

Overview 1

The North American Natural Gas Marketplace 3

Understanding
Natural Gas Markets
Natural Gas Demand 9

Natural Gas Supply 12

Summary 25

Glossary 26
Overview
Natural gas
is an important source
of energy for the United States.
Its importance has grown since the mid-1990s. Natural gas
is an attractive fuel because it is clean burning and efficient,
and because ample supplies of natural gas have been available
from domestic resources and from Canada. Throughout the
1990s, these factors and the low cost of natural gas helped
lead to increased investment in facilities using natural gas.
For example, the vast majority of new electricity generation
capacity built in the United States in the past decade has been
natural gas-fired. However, for the last five to seven years,
the price of natural gas has been trending upward (Figure 1).
Of course, the result of increasing natural gas prices has
been increased residential heating bills, increased fuel costs
to electric generators using natural gas, and decreased
competitiveness of U.S. industries that rely on natural gas.
Given the effect of higher natural gas prices on consumers’
budgets and on firms’ competitiveness, consumers, business
people, and policymakers are asking what has led to the
increase in North American natural gas prices.
1
Addressing these questions requires an understanding of three
important points:
 North American prices for natural gas are driven by the
interaction of natural gas supply available from North
American natural gas and oil fields and demand. Demand
depends, in large part, on the relative prices of other fuels,
economic growth, and weather, which drives heating
demand in the winter and demand for gas-fired generation
for cooling in the summer.
 The U.S. natural gas market is highly competitive.
Natural gas market prices are determined competitively
on spot and futures* markets reflecting current and
expected supply and demand conditions. The market
price is determined through the actions of thousands
of well-informed buyers and sellers.
 Natural gas consumed in the United States is primarily
produced domestically or imported from Canada. Planned
increases in U.S. imports of liquefied natural gas (LNG)
would, if realized, begin to integrate the United States
into a growing world market for natural gas.
* Italicized words appear in the glossary.
1
Average Natural Gas Spot Prices at Henry Hub, July 1996 - August 2006
Source: Platts
As described in this brochure, North America’s demand for
natural gas is strong as a result of continued economic growth
and other factors. In addition, high oil prices have made
natural gas a relatively more attractive fuel because fewer
industrial natural gas users can profitably switch from natural
gas to oil products for their energy needs. However, on
the supply side, despite increased drilling activity, North
American natural gas supply has leveled off due to the mature
age of existing natural gas fields. Furthermore, significant
natural gas resources are currently off-limits to development.
Political and market responses to high prices can include
increased conservation of natural gas, increased access
to currently restricted resources, improved extraction
technology, expansion of infrastructure to bring Alaskan
natural gas to the lower 48 states, and importation of natural
gas, both via pipeline from Canada and LNG from overseas.
2
The North American Natural Gas Marketplace
U.S. energy
counts natural gas as an
important part of its portfolio.
Natural gas provides 23 percent of the marketable energy
consumed in the United States.1 Oil products and coal
are the other two major sources of energy. Natural gas is
a valued source of energy because it is versatile and burns
cleanly. As a result, natural gas use is commonplace in
applications including cooking, residential and commercial
heating, industrial process feed stocks, and electric generation.
Physical Structure of the U.S. Natural Gas Industry
Figure 2 is a schematic illustration of the physical structure
of the natural gas industry and illustrates the principal
activities required to bring gas to consumers. The primary
activities are:
Exploration and Production
Exploration and production include finding and producing
natural gas from natural gas fields or associated gas that is
produced with crude oil.
Processing
Natural gas processing removes impurities and the higher-
valued products and prepares a dry gas stream that meets
industry standards for transportation in high-pressure
pipelines.
1 Energy Information Administration, “Energy Basics 101,”
www.eia.doe.gov/basics/energybasics101.html.
3
Transportation
Natural gas is transported in high-pressure pipelines from
producing areas to industrial end users, storage areas, and
local distribution companies.
Storage
The natural gas production and delivery system is not
designed to produce and transport the full amount of
natural gas consumers want during periods of peak demand.
In order to meet peak demand, large customers and
distribution companies put gas into underground storage,
mostly near final consumers. The stored gas is withdrawn
to meet consumers’ needs during times of peak demand,
such as a cold winter day.
Local Distribution
Local distribution companies own and operate the network
of pipes that carry natural gas from high-pressure trunk lines
to final consumers. These consumers include residential,
commercial, and industrial customers.
Liquefied Natural Gas
The United States currently imports about three percent
of its natural gas from overseas producers in the form of
liquefied natural gas. LNG can also be stored and used
to meet peak demand.
2
Physical Flow of Natural Gas

4
The North American Natural Gas Marketplace

3
Selected U.S. Natural Gas Producing Regions and Pipeline Flows
Source: EIA, Platts, State of Alaska Department of Natural Resources

Figure 3 shows some of the primary areas where natural

gas is produced in the United States. As the figure shows,
natural gas is found in a large number of states. Major
onshore production areas include the Rocky Mountains,
Texas, and Louisiana. In addition, significant natural gas
comes from offshore production in the Gulf of Mexico.

5
6
The North American Natural Gas Marketplace

4
U.S. Natural Gas Resources Subject to Access Restrictions (TCF)
Source: EIA, Platts, National Petroleum Council

As shown in Figure 4, offshore areas on both coasts and the
Alaskan Peninsula are off-limits to exploration. In addition,
approximately 125 trillion cubic feet (TCF) of the natural gas
underlying federal lands in the Rocky Mountains is off-limits
or under some type of restriction (such as species habitat
restrictions or no surface occupancy) and approximately 25
TCF of the natural gas off the western coast of Florida is
unavailable for exploration and production.2 As shown in
the figure, it is estimated that approximately 225 TCF of
U.S. natural gas reserves are off-limits to exploration, equal
to approximately ten times the total amount of natural gas
consumed in the U.S. in 2005 (22 TCF).3

2 National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands of a Growing
Economy, Vol. 2 at 127 (September 2003).

3 http://tonto.eia.doe.gov/dnav/ng/ng_cons_sum_dcu_nus_a.htm.

7
5
Breakdown of Natural Gas Price Paid by Residential Consumers During the Heating Season, 2001-2006
Source: EIA
Once natural gas is produced and processed, it is injected
into pipelines for transmission to customers and local
distribution companies. Transportation and delivery costs
are a significant portion of the cost of delivered natural gas.
The rates charged by both the natural gas pipelines and
the local distribution companies are regulated by federal
or state regulators.
In recent years, transportation and delivery charges have
declined from 62 percent to 42 percent of the final natural
gas price paid by residential consumers during the heating
season (November through March), while the cost of the
natural gas itself has increased from 38 percent to 58
percent of the consumer’s average heating season price
(See Figure 5).
8
Natural Gas Demand
In the late 1980s and early 1990s, demand for natural gas
grew rapidly in the United States, from around 17 TCF in
1983 to around 22 TCF in 1995, a 30 percent increase.
During most of this period, natural gas was a less expensive
source of energy than the oil products that it primarily
competed against. As a result, the low natural gas prices
Demand
for natural gas has grown rapidly.
of the 1990s and the expectation that prices would stay low
contributed to large investments in facilities, particularly
electric generation, that use natural gas. In addition,
increasingly strict environmental regulations and the
clean-burning qualities of natural gas have encouraged
many energy consumers to choose natural gas.
Figure 6 shows the consumption of natural gas by sector of
the economy. As the figure shows, the industrial sector is the
largest user of natural gas, typically consuming more than
35 percent of total use. Historically, the residential sector
has been the next largest user of natural gas, consuming
approximately 22 percent of the total. However, the use of
natural gas by electric generators has increased markedly
since the late 1990s, driven in part by the ease of getting
permits to build gas-fired generation relative to other types
4 http://www.eia.doe.gov/kids/energyfacts/sources/non
renewable/naturalgas.html#WHAT%20IT%20IS%20USED%20FOR.
9
of generation and by the low cost of natural gas. In fact, the
capacity of natural gas-fired generation has tripled since
1999, and the quantity of natural gas used by the electric
power sector grew by more than 50 percent between 1996
and 2005. Commercial use of natural gas for heating office
buildings and retail space has remained relatively constant.
More than 60 million U.S. households use natural gas for
water heating, space heating, or cooking. In total, natural gas
accounts for more than 50 percent of the fuel used to heat
U.S. homes.4 Residential and commercial heating demand for
natural gas is highly weather-sensitive, making weather the
biggest driver of natural gas demand in the short term. As
a result, natural gas demand is highly “seasonal” in nature,
with significant “peaks” in the winter heating season, as
illustrated in Figure 7. Natural gas pipelines and distribution
companies must plan to meet customers’ needs during the
peak demand periods. The seasonal nature of heating
demand can cause the price of natural gas to vary widely
at different times of the year.
6
U.S. Natural Gas
Consumption by Sector,
January 1990 -
December 2005
Source: EIA

7
Natural Gas
Consumption,
Production and
Storage Activity,
January 2001 -
June 2006
Source: EIA

10
Natural Gas Demand
As described on the previous page, the natural gas
production and transmission system is not designed
to move the full amount of peak demand from producing
areas to consumers. In order to meet high seasonal winter
demand for natural gas, a significant amount (ten percent or
more of our annual consumption) is put into storage during
periods of warm weather and lower demand. Figure 7
shows the pattern of natural gas production and storage.
The relatively flat purple line shows natural gas production
and imports into the United States. The figure shows
production remains
essentially flat throughout
the year, but, as the lighter
purple line shows,
consumption rises
dramatically in the winter
and falls in the spring
through the early fall.
Heating demand for natural
gas puts upward pressure
on natural gas prices during
winter, contributing to the
tighter market that exists
for natural gas in the winter
months, and serving to
compensate those who place gas in storage during lower-price,
off-peak periods. Regulated local distribution companies,
however, will place gas in storage for peak demand
independent of prices because of their regulator mandate
to be able to serve their customers’ peak demands. Thus,
natural gas inventory levels are driven, in part, by regulatory
factors in addition to market factors.
Despite the storage of natural gas and the industry’s
recognition that demand will rise in the winter months,
winter natural gas prices can fluctuate quite dramatically
11
with changes in weather and the amount of natural gas
in storage. The reasons for this price volatility are straight-
forward. For example, if storage levels appear to be low
in autumn, there will be concern that it will be difficult
to meet peak demands throughout the winter, and traders
may be willing to pay more to secure natural gas volumes
for winter month deliveries. This results in upward pressure
on market prices. In contrast, warmer than expected
weather during the winter of 2005-2006 led to storage being
quite full as the winter progressed and natural gas prices
dropped in response to
these ample supplies.
Available supply and
demand are tightly
balanced today. This
means, for example, that
an interruption of supply,
such as what happened
when hurricane damage
shut down substantial gas
production in the Gulf of
Mexico in 2005, can lead
to rapid and dramatic spikes
in prices. Investments are
intended to bring on new
supply, but new supplies require months or years to bring
online. And the short-term demand response to high prices
is constrained by the fact that many natural gas consumers
(especially residential and commercial consumers) do not
have the ability to switch to alternate fuels or to significantly
reduce their energy use in the short-term. In the longer run,
high prices do reduce demand. For example, some U.S.
industrial gas users like chemical and fertilizer plants have
shut down permanently.5 Weather and storage levels also
continue to influence natural gas markets on a seasonal basis.
5 National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands
of a Growing Economy, Vol. 2 at 292 (September 2003).
Natural Gas Supply

97%
Figure 8 shows the total domestic production of natural
gas in the United States. As the figure shows, domestic
production of natural gas peaked in 2001 and has declined
slowly since that time. In 2005, production was seven percent
lower than in the peak year 2001. This decline is, in part,
the result of the fact that some of the key natural gas fields
have matured and are less productive than earlier in their
lives, whereas new developments of unconventional resources
of the U.S. gas often have lower productivity. In addition, significant
undeveloped natural gas resources remain off-limits to

supply comes from exploration. Moreover, the reduced level of U.S. production
in 2005 is partly attributable to interruptions to offshore

domestic sources production as a result of hurricanes.

and Canada.
8
U.S. Natural Gas Marketed Production, 1990 -2005
Source: EIA

12
Natural Gas Supply

9
Historical and Projected Natural Gas Supply by Source, 1990-2025
Source: EIA

Figure 9 shows the sources of natural gas supply to U.S. Approximately 15 percent of U.S. natural gas consumption
consumers. In recent years about 82 percent has come from is imported from Canada. The remaining three percent comes
domestic sources. from LNG imports.

13
10
Natural Gas Production of the Gulf of Mexico Federal Offshore, 1992-2005
Source: Minerals Management Service
The production of natural gas from the Gulf of Mexico shows
the impact of the maturation of the gas fields in a producing
area on total production. Figure 10 depicts natural gas
production from the Gulf of Mexico and the share of that
production that comes from deepwater wells drilled in more
than 200 meters of water.
Total Gulf production peaked in 1997, but the decline in Gulf
production was slowed by the increased drilling of deepwater
wells. Today, approximately 38 percent of Gulf production
comes from deepwater wells. Thus, the industry has had to
move to more expensive resources and improved technology
to stem the decline of production.
14
Natural Gas Supply

11
Natural Gas Production by Source, 1990-2025
Source: EIA

Figure 11 shows the U.S. production of conventional Clearly, the tightening supply and demand balance in
natural gas, offshore natural gas (primarily from the North America helps explain the upward trend in natural
Gulf of Mexico), and unconventional natural gas, which gas prices over the last five to seven years. Conventional
includes natural gas from deep wells, coalbed methane, resources that are currently accessible to natural gas
tight sands, and other sources that are more difficult and producers are beginning to mature. As a result, producers
costly to develop than conventional resources. The amount have had to shift their efforts to resources that are more
of natural gas produced from unconventional resources difficult and more expensive to develop.
is increasing while production from conventional and
offshore resources is declining. Developing these
unconventional resources would be further facilitated
by advances in drilling and other technology and by
increased access to resource areas that are off-limits.

15
12
New Producing Natural Gas Wells and Wellhead Price, 1990-2005
Source: EIA
The natural gas industry has responded to higher natural
gas prices by increasing its efforts to find and develop
natural gas resources. Producers have sought out and
developed unconventional resources such as coalbed
methane, tight sands, and deepwater resources.
In addition, as shown in Figure 12, natural gas producers
have increased the number of wells drilled in the United
States from approximately 11,000 in 1999 to approximately
27,000 in 2005. Improvements in technology have also led
to increased success in drilling exploration and development
wells. As shown in Figure 13 (next page), the percentage
of dry wells fell steadily over the last decade.
16
Natural Gas Supply
13
Dry Rate for
Exploratory and
Development
Wells Drilled,
1990-2005
Source: EIA
As production from traditional U.S. supply basins including
the shallow portions of the Gulf of Mexico is flat or declining,
the United States will have to look to new sources and new
technologies in order to maintain its natural gas supply.
Increased Domestic Supply
In the continental United States there is potential for
increased supplies from the Rocky Mountain region,
deepwater sections of the Gulf of Mexico, and new areas.
Increases in natural gas supply in both the Rocky Mountains
and the eastern Gulf of Mexico are limited by drilling
restrictions, however.6
Canadian Imports
As in the United States, the Canadian supply situation is
characterized by declining production from mature supply
resources and increasing production from unconventional
resources as well as increased supplies from the Arctic region.
Thus, overall Canadian production is projected to remain
relatively flat and exports to the United States, after factoring
17
in expanding Canadian use, are expected to decline. Canada
is expected to use more natural gas to heat buildings and to
produce unconventional oil from tar sands, which uses heat
from natural gas. According to the Energy Information
Administration’s (EIA) most recent forecast, pipeline imports
from Canada to the United States reached their peak between
2000 and 2005, and will decline slowly but steadily for the
next two decades (see Figure 9). Expanded production in
developed areas in Canada and in the lower 48 states is
attractive because there is an extensive pipeline network
available in most areas that makes it possible to bring this
gas to market quickly. There are other potentially large
sources of natural gas available to U.S. consumers, but some
will require substantial investments for these supplies to be
brought to market.
U.S. Arctic Gas Supplies
Currently, the United States has large natural gas resources in
the Arctic regions of Alaska (e.g., Prudhoe Bay). Proved gas
6 National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands of a Growing
Economy, Vol. 2 at 127 (September 2003).
14
U.S. LNG Imports by
Month and Monthly
Average Natural Gas
Spot Prices,
July 1996-June 2006
Source: EIA, Platts

reserves on the North Slope of Alaska total approximately 45 developers have announced plans to build more than 40
TCF and potential reserves have been estimated to be more additional LNG import terminals.9 However, LNG terminals
than 250 TCF.7 These natural gas resources are currently not can be difficult to permit and build, and it is uncertain
connected to pipelines that can bring this gas to markets in how many of these planned terminals will eventually be
the lower 48 states, though there are plans to build such a constructed.
pipeline. This pipeline could carry as much as 4 billion cubic
feet (BCF) per day,8 or approximately seven percent of While most analysts agree with the forecast of the EIA that
average daily U.S. consumption in 2005. the contribution of LNG to overall North American natural
gas supply will grow, the ultimate contribution of LNG to
LNG Imports supply remains somewhat uncertain. Even accounting for the
The United States currently imports a small amount of natural increases in natural gas prices in the United States in recent
gas from overseas in the form of LNG. In response to high years, natural gas prices at times have been still higher in
natural gas prices in the United States, LNG imports rose other parts of the world, such as Japan and parts of Europe,
rapidly beginning in 2002, as shown in Figure 14. In recent that depend on LNG for a significant share of their natural
years, the United States has increased its capacity for gas supply.10 The growing role of LNG in North America
importing LNG by reopening old LNG terminals that were will increasingly connect what has been a regional market
built during the natural gas shortages of the 1970s and 1980s to the global market for LNG. As a result, U.S. natural gas
but were then mothballed when natural gas prices were low, prices will, over time (should this trend continue), increasingly
and by constructing new LNG import capacity. Moreover, follow global demand and supply trends, as do U.S. oil prices.
7 National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands of a Growing Economy, Vol. 2 at 110 (September 2003).
8 National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands of a Growing Economy, Vol. 2 at 202 (September 2003).
9 http://www.ferc.gov/industries/lng.asp#skipnavsub.
10 Natural Gas Week, “U.S. LNG Import Activity Picks Up with Softening of Global Market,” May 15, 2006, at 7.

18
Natural Gas Supply
How Natural Gas Is Traded
Figure 15 shows schematically some of the types of natural gas
transactions that take place as gas makes its way from the
fields where it is produced to end users’ burner tips. The
natural gas industry in the United States is highly competitive,
with literally thousands of producers.11 Some producers have
the ability to market their natural gas and may sell it directly
to local distribution companies or to large industrial buyers
of natural gas. (Some of these large industrial buyers are “on-
system” end users, meaning that they receive physical natural
gas deliveries from a local distribution company. Others are
“off-system end users,” meaning they are directly connected
to an interstate pipeline.) Other producers sell their gas to
marketers who have the ability to aggregate natural gas into
quantities that fit the needs of different types of buyers and
to transport gas to their buyers. Marketers may be large or
small and sell to local distribution companies or to
commercial or industrial customers connected directly to
pipelines or served by local distribution companies.
15
Commercial and Financial Arrangements
19
Most residential and commercial customers purchase natural
gas from a local distribution company. In contrast, many
industrial customers have the option to purchase natural gas
from a marketer or producer instead of from the distribution
company.
There are many different types of buyers and sellers who
are motivated to buy and sell gas under different types of
commercial arrangements. As a result, gas is sold on a spot
market basis, under longer-term contracts with fixed pricing
or terms that track market prices, and under contracts with
other types of pricing provisions. Marketers are able to
meet customers’ differing needs by bringing together a large
number of buyers and sellers. In addition, marketers and
other buyers and sellers of natural gas are able to use
financial instruments traded on exchanges to hedge the
risks associated with price volatility.
11 As noted previously, federal and state regulators regulate the prices charged by most natural
gas pipelines and local distribution companies for the transportation and distribution services
they provide. Natural gas prices themselves are not regulated today.
16
Natural Gas Market Centers Serving as Major Trading and Transshipment Points
Source: EIA

Note that pipelines do not buy and sell natural gas. Most
of the major natural gas pipelines are federally regulated
interstate pipelines. These pipelines are limited to providing
transportation services, including storage.12 Thus, pipelines
move gas at government-regulated rates on behalf of buyers
and sellers, but do not participate in the buying and selling
of natural gas.
12 Prior to the federal restructuring of regulation of the interstate natural gas pipeline system,
natural gas pipelines purchased gas from producers and sold it to the customers connected
to the pipeline. This system was inefficient because it severely limited the number of buyers
for natural gas and kept the market from operating competitively. These regulations were part
of the overall regulation of the natural gas industry that was dramatically altered beginning
in the late 1970s through the mid 1980s.
The domestic natural gas marketplace has a highly
competitive spot market where brokers and others buy and
sell natural gas. Figure 16 shows some of the points where
natural gas for physical delivery is actively traded in the
continental United States. These points are market centers
where brokers actively trade and prices are established.
In addition to these market centers, natural gas is actively
traded at many other locations, including segments of
individual pipelines and locations where pipelines
interconnect with local distribution companies.

20
Natural Gas Supply
The most important market center in the United States is
the Henry Hub, located in southern Louisiana, because it
is the most active and highest-volume trading point. The
Henry Hub is interconnected with 16 different intra- and
interstate pipelines and, thus, effectively interconnects to
all producing and consuming regions throughout North
America. Because of its central location and its high degree
of interconnectedness, the Henry Hub is used as the delivery
point for the New York Mercantile Exchange’s (NYMEX)
natural gas futures contract and a pricing reference point for
virtually the entire North American natural gas market.
Market participants buy and sell natural gas on a “spot” basis
every day at the trading points shown in Figure 16, as well
as at dozens of other points. Spot market transactions are
normally conducted over the internet or by telephone, with
the buyer agreeing to pay a negotiated price for the natural
gas to be delivered by the seller at a specified delivery point.
Natural gas spot prices reflect daily supply and demand
balances and can be volatile.
In addition to daily spot transactions, monthly spot
transactions are often entered during “bid week,” the last
five business days of a month. During bid week, buyers and
sellers arrange for the purchase and sale of physical natural
gas to be delivered throughout the coming month, including
making delivery arrangements with pipelines.
21
Many customers purchase natural gas under longer-term
contracts that provide for delivery of gas for a specified
period of time. The length of time can vary. Frequently the
prices in longer-term contracts are not fixed, but are instead
indexed to prices that are regularly published in the trade
press. A number of trade publications publish index prices
based on their surveys of natural gas buyers and sellers to
determine the prices they pay (or receive) for natural gas
(at market locations such as those shown in Figure 16) in
daily or monthly transactions.
Futures and Other Financial Contracts
In addition to the contracts for physical supply described
previously, natural gas derivatives are traded on the New
York Mercantile Exchange. A NYMEX natural gas futures
contract requires the seller to deliver (and the buyer to take
delivery of) natural gas at the contractually agreed price, in
a specified future month, at the Henry Hub.13 The price
to be paid for delivery in the future month when the futures
contract matures is determined at the time the contract is
sold. As expectations about the value of natural gas at the
time of delivery change, the value of the futures contract
will change as well.14
13 The NYMEX natural gas futures contract stipulates the purchase and sale of 10,000 MMBtu
of natural gas at the Henry Hub trading point in Louisiana in the delivery month. As noted,
the Henry Hub is the nexus of 16 intra- and interstate natural gas pipeline systems that
draw supplies from the region's gas supplies and serve markets throughout the United States.
14 Other NYMEX-traded natural gas derivatives include options contracts, calendar spread options,
and basis swap futures contracts. In addition to the derivatives available on NYMEX, market
participants trade other derivatives in over-the-counter (OTC) markets.
17
Natural Gas Futures Contracts Traded by Year, 1990*-2005
*Annual volume for 1990 begins in April | Source: NYMEX
Derivatives such as the NYMEX futures contract make it
possible for market participants to avoid the risk that results
from highly volatile natural gas prices in the physical market.
For example, a manufacturing facility that uses natural gas
may face highly volatile cash flows as a result of dramatic
fluctuations in natural gas prices from month to month and
day to day. To reduce these risks, the facility can purchase
physical natural gas using contracts with indexed prices and,
in addition, purchase financial derivatives that rise in value
when gas prices rise and fall in value when gas prices fall. The
result is that when prices are high, the value of the derivatives
will rise to offset the additional cost of gas, and vice versa.
The futures market for natural gas has grown rapidly from its
inception in 1990. Figure 17 shows the number of natural gas
contracts traded on the NYMEX each year between 1990
and 2005. This market is made up of a large number of
buyers and sellers, as well as different types of buyers and
sellers. Parties with commercial interests frequently use
futures contracts to reduce their exposure to price risk by
locking in the price they will pay (or receive) for natural gas
to be delivered in some future month. For example, a natural
gas producer who expects to produce and sell natural gas
each month for the next several years can use the NYMEX
futures contract to lock in the price that the producer will
receive for that gas.
22
Natural Gas Supply

18
Weekly Open Contracts by Trader Type, January 2000 - September 2006
Source: The Commodity Futures Trading Commission (CFTC)

In addition, the market includes a growing number of parties
who do not have a commercial interest in the natural gas
industry. Non-commercial parties buy and sell futures
contracts in response to contract prices (rather than to hedge
natural market positions) and in doing so they provide
insurance to commercial parties and liquidity to the futures
market. As shown in Figure 18, open contracts held by these
non-commercial traders have increased dramatically since
early 2002. The market benefits from the trading activity
of all types of traders because to trade effectively over a
sustained period, these parties must be well-informed, and
their participation in the market ensures that market prices
reflect all of the information available about current and
future supply and demand conditions.

23
19
Natural Gas Futures Settlement Price as of April 14, 2003
Source: Platts

Futures markets also provide valuable information about
expectations for supply and demand conditions in the
physical market that will determine the price for gas
scheduled for delivery on a specified future date. For
example, if in 2005 the price of a futures contract for the
delivery of gas in April 2006 is $8 per MMBtu, this
represents thousands of buyers’ and sellers’ best estimate
of what the price (in this case, increase) of gas will be for
physical delivery in April 2006.15 This price discovery
function is beneficial because it provides market information
to those who can best respond by, for example, putting
additional gas in storage or taking steps to switch to a
different fuel.
Figure 19 provides a snapshot of futures contract prices on
a day in April 2003. The figure shows prices for natural gas
to be delivered in each of the next 36 months. The futures
contract prices reflect buyers’ and sellers’ expectations as
of April 2003 that spot natural gas prices would be higher in
future heating seasons (October through March) and lower
in non-heating seasons (April through September).
15 Markets rely in part on the number of buyers and sellers involved for credibility of pricing.
The result – a reported price that reflects what multiple parties are willing to pay or receive –
provides efficiency and reduces costs.
24
Summary

Market
Driven
The U.S. natural gas market
is highly competitive.
Thousands of U.S. companies produce natural gas and
thousands of consumers purchase it, every hour of every day.
The steep rise in natural gas prices in recent years reflects a
natural market response to the tight supply and demand
balance. Demand for natural gas has been strong, especially
from the power sector where gas-using capacity tripled after
1999. On the supply side, most natural gas consumed in the
United States is produced from relatively mature fields in
the United States or Canada, where more intensive (and
costly) effort is now required to maintain production levels.
Continued improvements in technology will be required to
maintain production from existing fields. Other supplies
from new sources, such as Alaska’s North Slope, and some
increase in LNG imports are anticipated to offset declines
in domestic production. Moreover, allowing access to
additional resources that are currently off-limits would
enhance the domestic supply of natural gas.

25
Glossary
British Thermal Unit (Btu)
A British Thermal Unit (Btu) is the amount of energy
required to raise the temperature of one pound of water
by one degree Fahrenheit. This is the most common unit
used for buying and selling natural gas. A typical home
in the U.S. Midwest using natural gas for heating will
use approximately 14 MMBtu during a typical month
in the heating season.
Coalbed Methane
Coalbed methane is natural gas contained in coal deposits.
Typical recovery entails pumping water out of the coal to
allow the gas to escape.
Cubic Foot (cf)
A cubic foot (cf) is a standard measure of natural gas, equal
to the amount of natural gas contained at standard
temperature and pressure (60 degrees Fahrenheit and 14.73
pounds standard per square inch) in a cube whose edges are
one foot long. There are 1,031 Btu in a cubic foot of natural
gas. BCF (billion cubic feet) and TCF (trillion cubic feet)
are common abbreviations used in the natural gas industry.
Deep Gas
Deep gas is natural gas found at depths greater than the
average for a particular area; for FERC purposes, it is gas
found at depths of more than 15,000 feet.
Deepwater
Deepwater natural gas is natural gas located in the Gulf
of Mexico in waters at least 200 meters (656 feet) deep.
Dry Gas
Dry gas is natural gas which remains after: 1) the
liquefiable hydrocarbon portion has been removed from
the gas stream (i.e., gas after lease, field, and/or plant
separation); and 2) any volumes of nonhydrocarbon gases
have been removed where they occur in sufficient quantity
to render the gas unmarketable. Note: Dry natural gas is
also known as consumer-grade natural gas. The parameters
for measurement are cubic feet at 60 degrees Fahrenheit
and 14.73 pounds per square inch absolute.
Dry Wells
Dry wells are exploratory or development wells found
to be incapable of producing either oil or gas in sufficient
quantities to justify completion as an oil or gas well.
Futures Contract
A futures contract is a binding, legal agreement between
a buyer and a seller for delivery of a particular quantity
of a commodity at a specified time, place, and price.
These contracts are traded on regulated exchanges and
are settled daily based on their current value in the
marketplace. Most natural gas futures contracts traded
on the New York Mercantile Exchange (NYMEX) end
without actual physical delivery of the commodity.
Futures contracts most often are liquidated or cancelled
out by purchasing a covering position prior to the delivery
date and are generally used as a financial risk management
and investment tool rather than for supply purposes.
Liquefied Natural Gas (LNG)
Liquefied natural gas (LNG) is natural gas that has been
liquefied by reducing its temperature to -260 degrees
Fahrenheit at atmospheric pressure. This liquefaction
process reduces the volume of the gas by approximately
600 times from its original size.
Maturity
Maturity refers to the relative state of development of
natural gas resources in a field, reserve, basin, or other area.
In common usage, a “mature field” is one whose natural gas
production has begun to decline. A “mature basin” is one
that has undergone extensive exploration and production
activity such that it is assumed relatively few large fields
remain undiscovered.
Continued on next page
26
Glossary

Over-the-Counter (OTC)
Over-the-counter (OTC) transactions are not done on an
organized exchange.

Reserves
Reserves are estimated quantities of natural gas that analysis
of geologic and engineering data demonstrates with some
probability are recoverable under existing economic and
operating conditions.

Spot Market
The natural gas spot market is a market in which natural
gas is bought and sold for immediate or very near-term
delivery, usually for a period of 30 days or less. The
transaction does not imply a continuing arrangement
between the buyer and the seller. A spot market is more
likely to develop at a location with numerous pipeline
interconnections, thus allowing for a large number of
buyers and sellers. The Henry Hub in southern Louisiana
is the best-known spot market for natural gas.

Tight Sands Gas

Tight sands gas is a form of unconventional gas located in
low-permeability sandstone.

Unconventional Gas
Unconventional gas refers to natural gas extracted from
coalbeds (coalbed methane) and from low-permeability
sandstone and shale formations (respectively, tight sands
and gas shales). Unconventional gas has become an
increasingly important component of total U.S. domestic
production over the past decade. Although unconventional
gas resources are abundant, they are generally more costly
to produce.

Source:
Energy Information Administration (http://www.eia.doe.gov/).

27
A Policy Analysis Study by Lexecon, an FTI Company

Principal Authors
Charles Augustine
Bob Broxson
Steven Peterson

Research Assistance
Siko Sikochi

Undertaken for API

Copyright 2006 - API, all rights reserved.

2006-064 | 11.06 | 2M